NPTEL-Economics-Public Economics

Module 4
Lecture 18
Topics
4.20 Private Sector Under Provision Revisited
4.21 Provision of Public Good: Revisited
4.22 Lindahl Equilibria: Properties
4.22.1 Lindahl Conditions
4.22.2 Lindahl Pricing: Intuition
4.22.3 Lindahl Equilibrium

4.23 Lindahl Pricing: How Much Public Goods to Provide

4.20 PRIVATE SECTOR UNDER PROVISION REVISITED

In general decentralized private mechanism under provides public goods.
Consider two goods P and G and two individuals A&B, as before.
Here we analyze the case of private sector under provision and pareto efficiency more
formally.
Two individuals A & B
.
Private good P & a pure public good G.
Price of each good normalized to 1. (1-1 transformation technology).
Each household starts with endowment
of good P.
Out of
individual h contributes
to public good funding.
available for every one
Consumption units are one to-one with respect to expenditure since price = 1
Consumption of private good
.
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Individual h solves
Subject to
Nash equilibrium outcome is given by
i.e.
Rule for optimal public good provision, Samuelson rule, is not satisfied.
Pareto improvement possible if each person invested

more Rupees in the

public good.
Each person contributing

total contribution

Assuming an additive utility function, with 1 more unit of G, net welfare change
for h is:
= (gain in utility from 1 extra unit of public
good) + (1/H) (Fall in utility from giving up 1/H amount of private good)
Pareto Improvement

Decentralized Private provision suboptimal

Market outcome is inefficient and there is under provision of G.

4.21 PROVISION OF PUBLIC GOOD: REVISITED

Samuelson rule simple but difficult to implement in practice.
Govt needs to know preferences
Issue of how to finance the public good
Samuelson analysis is a first-best benchmark
How to achieve Pareto efficiency through a decentralized mechanism?

4.22 LINDAHL EQUILIBRIA: PROPERTIES

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4.22.1 LINDAHL CONDITIONS

Public good must be fully financed
All individuals must demand same quantity of G
Samuelson Rule applies and outcome is Pareto efficient
With identical individuals, simply set tax t = 1/H (H= total number of
individuals/households) and ask individuals to voluntarily contribute to G
With heterogeneity, efficient outcome can be attained with public goods through
prices that are individual-specific

4.22.2 LINDAHL PRICING: INTUITION

Ideally, the government could provide public goods through unanimous consent
of its citizens.
Lindahl pricing: Individuals report their willingness to pay for each quantity of
the public good, and the government aggregates preferences to get social benefit.
First, the government announces tax prices for the public good, that is, the share
of the cost that each individual must bear.
When a tax price is arrived at where both individuals want the same amount of the
public good, the government has reached Lindahl equilibrium.
Private goods: Individuals maximize utility by letting marginal rates of
substitutions equal the relative price. Since in a competitive equilibrium all
individuals face the same relative prices, the implication is that marginal rates of
substitutions are equalized across all individuals, resulting in a pareto efficient
allocation. All individuals face the same price, but may consume different
quantities of goods.
- Consumption differs price the same.
Public goods: Individuals have to consume the same amount of public good, thus
individuals cannot equalize their marginal rates of substitutions to the common
relative price. If consumption of the good must be the same it is possible to vary
prices across individuals to get efficiency.

- Consumption same price differs.

4.22.3 LINDAHL EQUILIBRIUM
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How to achieve pareto efficiency through a Decentralized mechanism?

Suppose individual h has to pay a share
level of G.
individual h chooses G to maximize

of the public good & can pick a

Without any public good his utility is

First order condition for utility maximization for individual h:

Demand for:

A Lindahl equilibrium satisfies the following conditions

(1) public good must be fully financed
(2) All individuals must demand same quantity of G.
Existence of prices,

satisfied: (1) H equations

& H unknowns
Samuelson rule applies and outcome is pareto efficient

With identical individuals simply set

and ask individuals to voluntarily
contribute to G.
With heterogeneity, efficient public good allocation can be attained through
prices that are individual specific.

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Figure 18.1
Suppose As demand curve for public good is steep and Bs demand curve for public
good is flat.
Aggregate demand:
Vertical sum
With SMC =1 (remember price of G=1). It is beneficial to produce the good.
Suppose the socially efficient level of G is 75
This generates a tax price of

for A

This generates a tax price of

for B

As Surplus =E F G
Bs Surplus = H I J
The production at 75 is equilibrium for 2 reasons:
(1) Both A & B are happy to pay those tax prices to get that quantity.
(2) Government has covered the marginal cost of production by charging each
person their marginal willingness to pay.

4.23 LINDAHL PRICING: HOW MUCH PUBLIC GOOD

TO PROVIDE
The government chooses some initial tax share and informs consumers.

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Each person announces how much of the public good he or she wants at those tax
prices.
If everyone demands the same level of public good, then provide that level & split
the cost according to tax share.
If the individual announcements differ, the government raises the tax price for the
person who wants more of the good, and lowers it for the person who wants less.
Provision decision effectively secured through unanimity.

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Indian Institute Of Technology, Kanpur